It’s a vicious circle long familiar to those in traditional finance: trades made with borrowed money coming apart when the value of their collateral put up against the loans drops, forcing liquidations that in turn push prices down further.
That pattern, driven by so-called margin calls, has come to cryptocurrency markets in a big way since prices began to slump broadly — with some additional crypto-only twists.
1. What’s a margin call?
In traditional markets, trading with borrowed money is called borrowing on the margin. The lenders, usually brokers, require that collateral, usually in the form of other stocks, be posted to offset the risk of the trade going sour. The collateral requirement is defined as a percentage of the loan. That means that if the value of the collateral drops, the broker will call for the investor to either post more collateral or close the position and repay the loan.
2. How can margin calls disrupt markets?
The system usually works well enough when markets are going up or are roughly steady, though individual investors who make bad bets or get in over their heads can suffer. Bigger troubles can come when there’s a broad fall in values that triggers widespread margin calls. When investors sell holdings to meet a margin, they drive prices down further, prompting further margin calls.
3. How is this different in crypto?
For one thing, the DeFi (decentralized finance) apps on which much crypto trading takes places tend to be interconnected, meaning troubles in one can have cascading effects on another. For another, most DeFi apps require overcollateralization — that an amount of crypto greater than the loan be posted, to account for the normal volatility seen in this market. But perhaps most important is that liquidation of positions when margin calls aren’t met usually happens automatically: The so-called smart contracts used to execute trades will turn the positions over to bots designed for this purpose. There’s no chance to convince a broker that you will be able to cover your position if given another day, hour or minute.
4. What happens when liquidations are triggered?
Many DeFi apps offer a liquidation bonus to the bots, which are run by third-party programmers and traders. That incentive can lead to swarms of them competing to carry out the liquidations, a situation that can clog up the blockchain ledgers used to process and record crypto transactions. And as with any other kind of margin call, a large number of liquidations — or the liquidation of a large holding — can drive down token prices, leading to more liquidations.
5. How bad is the situation?
The pain now buffeting DeFi apps was triggered after centralized crypto lenders Celsius Network and Babel froze deposits and the rumored collapse of fund Three Arrows Capital sent crypto prices down by double digits over the course of a week. Celsius had worked with many DeFi apps to earn the high returns it offered. Much of the market turmoil focused on stETH, a token that represents staked Ether on the Ethereum blockchain and counts Celsius as a major holder. Since its launch by decentralized app Lido Finance, stETH has become one of the most popular collateral assets for lending and borrowing in DeFi. But stETH began trading at a deepening discount to Ether’s price, which has led both to liquidations and illiquidity in its trading. About 30% of all stEth stuck on Aave, for example, was from Celsius, according to researcher Novum Insights. Three Arrows Capital, meanwhile, was an investor in Lido, which issued stETh. As tracked by DeFi Llama, the total value locked in DeFi, the amount of crypto in use on apps, plunged to $76 billion on June 24 from $205.7 billion on May 5, just before the Terra blockchain’s implosion set off the year’s biggest crypto crisis so far.
6. What has been the response?
Some unprecedented steps were taken, though some of them were rescinded. On June 19, token holders of Solend, a lending app on the Solana blockchain, voted to temporarily take over a large user’s account that faced the threat of a large liquidation, an extreme move for DeFi that appeared to be a first. That decision, which was meant to provide an orderly over-the-counter liquidation rather than a bot-driven firesale, was reversed in a follow-up vote. A slew of other apps moved to adjust their practices and policies to stave off large-scale liquidations and consequent losses.
7. What’s the significance of all this?
During the bull market, many crypto traders appeared to have forgotten just how risky crypto and DeFi loans in particular can be. The wave of liquidations that washed over the industry seemed to prompt more people to become more cautious with borrowing. On decentralized exchange dYdX, for example, traders have dramatically reduced their leverage since Terra’s crash.
(This story has not been edited by NDTV staff and is auto-generated from a syndicated feed.)